Answer: I would need to know more about your lawsuit. There are five possible outcomes for legal fees paid pursuant to a lawsuit, but you should be limited to two of these possibilities for an employment-based claim.
The general rule is that the legal fees are deducted as miscellaneous itemized deductions. Your tax benefit is then limited to the excess of all such deductions over 2 percent of your adjusted gross income (AGI). But these deductions are not allowed for alternative minimum tax (AMT) purposes.
So to illustrate let’s say you get a $250,000 settlement and have $100,000 in legal fees. If you have $50,000 of other income, your AGI is $300,000, and you can deduct $94,000 of legal fees ($100,000 minus 2 percent of $300,000).
But your deductions for AMT purposes are zero, and you will likely become subject to AMT for the year of the settlement just because of the difference in the treatment of the legal fees.
A deduction is allowed “for” AGI, which means it is reported on the first page of your tax return and is not subject to any AMT adjustment, if the legal fees relate to certain unlawful discrimination claims.
There are 18 different types of discrimination claims that allow this favored tax treatment for legal fees, and they are listed in Section 62(e) of the Internal Revenue Code.
I do not know the specific nature of your claim, nor do I have the ability to evaluate the nature of the claim even if you attempted to tell me. So I would ask your attorney to look to the Section 62(e) claims and see if you can qualify for any of the exceptions to the general tax treatment described above.
If your claim is on the Section 62(e) list, I would recommend that the settlement specify that is relates to one of the specific actions found in Section 62(e).
Q: My wife and I formed an LLC two years ago to hold eight rental properties. We then gave 40 percent of the interest to our two children and their spouses. We have a simple agreement that says that they have 40 percent of everything. We have made improvements to several of the properties and have funded all expenses. Because we are in a higher tax bracket than the kids, my question is if it is OK for us to claim all tax deductions?
A: The general rule is that items of income and deduction that are reported by a partnership are allocated to the members in whatever manner the agreement specifies. This general rule would give you only 60 percent of all deductions.
This general rule does not apply, however, if it lacks “economic effect.” That is, the tax effect must match the economics for the agreement to be respected.
The tax law recognizes that if a partnership reports an item of income, that income is typically associated with an economic benefit. Similarly, a deduction is typically associated with an economic detriment.
So without regard to what the agreement says, if it can be shown that a particular partner or partners bears the economic detriment associated with a deduction, that deduction must be allocated to the partner who suffers the detriment associated with the deduction.
Generally one cannot show a direct link between a deduction and a particular partner who bears the associated economic detriment. However, if partnership records show that you and your wife funded all deductions, the economic effect test would require that only you be allocated those deductions.
If you can prove the link between the deduction and your economic payment, the agreement to allocate 40 percent to the kids cannot be respected because it lacks economic effect.
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